The Problem with Crypto Financial Reporting
I read the Coinbase 10-K (The Annual Financial Report); here's what I realized is missing.
TL;DR: When it comes to Crypto Financial Reporting, there is a bias for US Dollar, and no representation from Crypto unit/tokens.
Hello Curious One.
This piece took me a while to pen and think out. Originally inspired by the question “What are the risks of using blockchain from an Enterprise Risk Management standpoint?” which was asked by Sophie L., I spent sometime thinking about risks beyond the normal “Cybersecurity” and “we need talent”.
Before I can respond to what’s the risk, let’s look at what we do have.
This question that was asked has somehow compelled me to read the Coinbase 10-K. I’ve summarized some of it here, though that document is huge. I was focused more so on the Crypto angle.
Next week you’ll see a piece going through blockchain risks and proposals to modify a 10-K.
As always, you’ll find TL;DR: and graphics at the beginning of each section.
Good reading!
In Case You Missed It
Sections You Can Skim To
The Problem with Crypto Financial Reporting
Looking at Coinbase’s Financial Reporting
What are Coinbase’s Crypto Disclosures?
What is Missing from the Report?
Scenario #1 - Digital Asset Valuation Volatility
Scenario #2 - Blockchain Platform Case Scenario
Scenario #3 - DeFi Protocol Case Scenario
The Problem with Crypto Financial Reporting
TL;DR: Crypto is measured and presented in US Dollars, but not in native Cryptocurrency units
Crypto is often represented by the proxy value to US Dollars. Proxy in a sense that companies are indicating “we are representing Crypto not directly, but instead we’re going to use US Dollar as a close representative”.
You can sub US Dollar for your choice of fiat currency.
There are three sets of things that have to be in place for the above model to accurately play out:
The Native Units are Accounted For
The Translation Measurement Methods are rationale, and verifiable
The US Dollar Translation is Accounted For
There are a lot of clerical what-could-go-wrongs here, and given Crypto’s ability to be a fluid financial instrument that can take on different intent and usage, and even be a combination of several tools, measuring crypto from a financial point of view is a difficult task.
But at core, Crypto gets reported at the US Dollar Value, with no reporting on the Crypto units themselves.
Which means a lot of Crypto-specific movement gets lost.
This makes it very hard to see what is a Crypto Business, versus what is a regular business. Unless there are certain disclosures, I would consider it hard to evaluate a Crypto business especially under conditions of consistent volatility.
So what can we do about that?
Looking at Coinbase’s Financial Reporting
TL;DR: Almost every single Crypto disclosure from the Coinbase 10-K is presented in US Dollars, and doesn’t show Crypto assets (tokens) held.
I read the 2021 10-K for Coinbase that came out in February 2022. If you are unfamiliar with what a 10-K is, it’s a publicly traded company (anything with buyable stock) annual financial statement report, complete with an independent financial auditor’s assessment. This report is shared publicly, but its aimed at investors.
Everything you see in a 10-K can be referred to as a disclosure. Disclosures are what the the Company’s Management is required to tell you, and can also include things they want to tell you.
Companies do not get to choose what they have to disclose, nor how things get disclosed. That’s the regulated part, and in the U.S., that is mandated by the U.S. Securities Exchange Commission, or the SEC. If a financial or business significant event happens that the U.S. SEC says you must disclose, then you have to report it to the SEC.
Additionally, the way financial numbers get presented in the U.S. is called GAAP, or generally accepted accounting principles. Basically a group of Certified Public Accountants (CPAs) have been working together since 1939 to tell you how numbers ought to be accounted for. These are now referred to as accounting principles, which is conveniently organized as ~90 Accounting Topics. It was in the last two decades where the financial reporting rigor heated up.
Coming back to Coinbase-
Here’s how they did (2021 10-K for Coinbase):
Revenue:
$7.8b in Rev
It grew 5x 2020's /// 13x 2019’s
Expense:
$4.7b in Expense
It grew 4.5x’s 2020 /// 7x 2019’s
EBITDA:
$3.1b
It grew 6.4x 2020’s /// 3000x 2019’s
Net Income:
$3.6b
It grew 10x 2020’s /// 3600x 2019’s
Geographic Share:
80% US based Revenue
20% rest of the world
On paper, Coinbase as a company is doing great. It had high trading volume and quite the market presence.
In 2019 Coinbase had around 1250 employees, and 5x to 6,000 employees by Q1 2022.
Except, I couldn’t figure out the Crypto part of the business.
Just how much of the Coinbase financial performance was based on the overall rising value of Crypto?
I’m thinking about how Bitcoin went from $29k to $60k - a 2x return for some.
I’m also thinking about what happens in scenarios where Crypto tanks.
What are Coinbase’s Crypto Disclosures?
TL;DR: Almost every single Crypto disclosure is presented as a function of the US Dollar.
Looking at Coinbase’s 10-K - I focused on how Crypto itself is presented. Coinbase is the first major crypto company to go public, and we can safely bet that many legions of financial auditors and SEC reporters will be looking to Coinbase’s 10-K for everything.
So how did Coinbase present Crypto?
Crypto Assets Held for Investment?
$696 at Fair Value
It’s in US Dollars. Native units (amount of tokens, for example) is unknown.
Crypto Assets Held for Operating Purposes?
$440.8m at Fair value
It’s also presented in US Dollars
Crypto Assets on the Platform?
40% Bitcoin and 25% ETH.
All calculated by the dollar value of each crypto asset (All in 2021).
Trading Volume of Crypto Asset?
Bitcoin is 24%
ETH is 21%
Other is 52%
All calculated by their US Dollar valuation. No breakdown for “Other”.
NFTs held for investment? Just kidding, I don’t think that’s relevant to Coinbase. It will be for other Crypto Investing Companies though.
As I was looking at the 10-K, I couldn’t help but wonder: If we took away everything related to Crypto, and simply made all Crypto worth $1 each, what would be the impact? And then the more grand question-
Is reporting in US Dollar a helpful metric for Crypto-Specific Businesses?
Answering this in the most consulting way I know - it depends.
Just kidding.
My opinion in working in a heavily not-at-all regulated, super volatile, and at some point, completely far fetch space that is Crypto - it’s not useful enough and we’re going to need a lot more disclosures.
What is Missing from the Report?
TL;DR: For starters, the Crypto Units Part. But more importantly Crypto-specific disclosures.
How do I know what part of the Company’s performance is impacted by the action and activities of the Company, versus what part of is impacted by external factors?
Specifically, how do I know how much of the company got lucky from rising Crypto Prices it can’t control, versus the company’s ability to attract users and monetize?
If I remove US Dollar Proxy Measurement issue from any crypto company, crypto “protocol”, or anything related to cryptocurrency, how well is that individual company performing?
To answer that, I’d need to have access to Crypto Financial Statements - balances before they get converted to US Dollars - presented like traditional financial statements.
Let’s explore the train of thought through 3 scenarios.
Scenario #1 - Digital Asset Valuation Volatility
Let’s assume you are in the business of software development, and your company offers goods and services in exchange for Solana, a type of Cryptocurrency. You started operating in 2022.
In Quarter 1 of 2022:
Your company earned 50,000 SOL.
The average sales transaction size is 10 SOL.
To get 50,000 SOL, you sold to 5,000 customers.The US Dollar Value of 1 SOL in the period is $100.
Congratulations!
In Q1’22, your company sold to 5,000 customers,
earned 50,000 SOL,
which is worth $5,000,000 US Dollars.
Without disclosing any other information, you would think this is a pretty successful operation.
Before moving on, ask yourself - why do you think that is?
Would your perception change if SOL was worth $80?
How about $200?
In Quarter 2 of 2022:
Holding everything true, your Company earned another 50,000 SOL
The US Dollar Value of 1 SOL dropped 75% for Q2 - SOL is now worth $25
You still maintained the same sales SOL Sales volume, by SOL units.
Congratulations!
In Q2’22, your company sold to 5,000 customers still,
earned 50,000 SOL still,
which is worth $1,250,000.
Comparing Q1 to Q2
Let’s assume everything about Q1 and Q2 performance, besides SOL to USD value, is the same.
In Q1'22, you earned $5m
In Q2’22, you earned $1.25m
You sold to 5,000 customers in Q1, you sold to 5,000 customers in Q2 - that’s a total of 10,000 customers.
Yet, the difference is $3.75m as a result of SOL to USD Valuation Drop.
My Question to you:
If you weren’t the owner of the business, but a potential investor that could buy 10-49% minority stake, would you? What would have to be true?
Scenario #2 - Blockchain Platform Case Scenario
TL;DR: Your Choice of Blockchain(s) = Your Platform Risks
Your company operates in Solana.
A major ecosystem wide vulnerability that is beyond your company’s direct influence and ability to stop has been identified that the broader communities estimate it can take 3 weeks to 3 months to understand, develop a patch, propose implementation to the ecosystem governance, and execute on.
In this time, your main product suffers directly from that vulnerability, and customers are a lot more hesitant in buying Solana-based goods in general.
What’s the risk, and how would you respond?
What would your investors need to be aware of?
Scenario #3 - DeFi Protocol Case Scenario
TL;DR: External Entity Can Influence Crypto Price and Platform Stability
A new DeFi protocol utilizing only Solana crypto has sprung up, and in a short period it has 25% of all Total Solana Tokens in the Market interacting (including deposited) with it.
The protocol offers 20% interest to all those who “bank” with them, even though you don’t understand or agree with the benefit it gives back to the ecosystem.
It was discovered that the DeFi protocol is experiencing outages and issues. While minor, some users of the DeFi protocol no longer have access to their cryptoassets that are banked on the DeFi protocol.
You observe and the issue is cascading across that community.
What’s the risk, and how would you respond?
To understand why DeFi Protocols are a scenario, check out this prior publication I did.
Closing Comments:
Crypto is measured and presented in US Dollars, but not in native Cryptocurrency units. As a consequence, investors are missing a lot of key insights.
If we return to Scenario 1 - Under a US Dollar measurement, the performance of your company in Q2 compared to Q1 is “your company did poorly and negatively grew compared to Q1”.
Even though you earned the exact same amount SOL, had the exact same amount customers, you were hit with a Solana USD Devaluation that you can’t control.Scenario 2 focuses on platform risks - some technology changes are out of your company’s control. Blockchain is quite literally outsourced computing and transactional data keeping, but it comes with trade offs.
Scenario 3 focuses on DeFi Protocols. I could go on an endless tirade here, so I’ll save it for another publication (next week!).
Thanks for reading :)